Category Archives: interest rate policy

Cruz Champions Sound Money

By Barry Elias | Thursday, 03 Dec 2015 11:05 PM

The primary function of the Federal Reserve should be to stabilize the U.S. Dollar.

This view has been voiced recently by former Federal Reserve Chairman Paul Volcker and 2016 republican presidential candidate Senator Ted Cruz from Texas.

By stabilizing the dollar, real income for the masses will once again increase tremendously, thereby reversing a 40-year trend of income stagnation for the bottom 90 percent (the striving majority), according to Put Growth First, an organization that advocates for pro-growth monetary stability and supply side tax reform, and has provided advice to the several 2016 republican presidential candidates, including Senator Ted Cruz of Texas.

(Disclosure: I am an economic advisor to Put Growth First.)

Annual inflation-adjusted GDP growth from 1790 to 1971 averaged nearly 4 percent.

However, since 1971 – the advent of the floating paper dollar backed only by empty political promises, but no real intrinsic value – yearly growth slid to 2.8 percent, and since 2000, it fell further to 1.7 percent per annum.

Moreover, the future prospects are dismal: the Congressional Budget Office and Social Security Trustees now project real economic growth of slightly more than 2 percent.

From 1948 through 1971, the bottom 90 percent experienced a cumulative rise in real income of 85 percent according to the 2012 World Income Database.

Why was this happening?

During this time, the value of the dollar was stable and the Fed did not employ a single labor market variable on its dashboard of indicators. It was up to business to invest so productivity kept pace with wage growth.

A stable dollar permitted more stable material costs for businesses and less demand for expensive financial hedging.

This allowed capital to flow toward more productive investments that generated employment and income for the many – instead of exotic financial products that tend to rely on arbitrage and speculation that extract equity rather than enhance wealth.

The result was faster economic growth. And, despite strong income growth for the striving majority, business profits relative to GDP remained strong and steady.

The situation changed drastically in 1971 when the U.S. dollar lost its intrinsic value anchor and began floating. Since then, real income for the bottom 90 percent (the striving majority) stagnated while that for the top 10 percent grew an additional 140 percent.

Lost economic activity due to the lower growth rate since 1971 totals $104 trillion: $75 trillion since 2000 and nearly $9.2 trillion in 2013 alone. The total inflation-adjusted cost of all U.S. military wars is $7.7 trillion, according to the Congressional Research Service and Stephen Daggett, a specialist in Defense Policy and Budgets. In other words, stagnation has caused more destruction than all wars combined.

Had the 1948-1971 trend for real income of the striving majority continued, the bottom 90 percent would be earning 2½ times more than they do now. If income for the striving majority was 2½ times greater today, how many of our current problems would still be problems?

What happened?

Since the dollar was no longer stable, the Fed surreptitiously began targeting wage growth as an indicator of inflation that needed to be curtailed.

This is because inflation was redefined to mean an increase in a price index rather than a decline in the value of the dollar. To keep the index from going up, they have raised interest rates every time we’ve had decent wage growth in the last 30 years. This squelched the growth along with wages and employment opportunities, causing volatile business cycles and stagnation.

This theory was promoted in the 1970’s, which suggested there was a tradeoff between unemployment and money wage inflation as depicted in the Phillips Curve.

However, empirical evidence has contradicted this model over several decades and it has become more apparent that inflation is a function of the supply and velocity of money relative to the total quantity of goods and services provided in the general economy.

Also, the Fed was given a dual mandate by Congress in the late 1970s, to minimize and stabilize unemployment in addition to inflation. Unfortunately, the Fed lacks proper tools to deal with unemployment, since it involves fiscal policy to a large degree.

In essence, the Fed was acting in a reactionary manner, since inflation and unemployment are lagging indicators, have subjective measurements and are constantly revised.

Moreover, the policy intervention has lag built into it; by the time it became operational, the underlying conditions that were being addressed may have changed. Therefore, too often we were treating the wrong problem with the wrong solution at the wrong time, causing severe business cycle volatility.

During Senate testimony, Janet Yellen (now Federal Reserve Chairwoman) said, “A key lesson of the 1970s is the critical importance of maintaining well-anchored inflation expectations so that a wage-price spiral like we saw back then does not break out again.”

There have been numerous times that Yellen has referenced strong labor market conditions as a potential source of inflation, which the Fed needs to keep in check – primarily via increased interest rates.

However, the goal of the Fed should be to maintain the stability of the dollar as a unit of measure, and not guided by fiscal parameters, such as wage levels, that the Federal Reserve Bank has little control over.

Partially backing credit and currency formation with the production of real assets, such as gold, silver and virtual currencies using market-driven pricing, would couple money supply growth with the productive use of resources, including land, labor, and capital, and lead to more productive investment of that credit. In addition, business borrowing will be predicated on well-developed ideas that have greater likelihood of being executed effectively.

As a result, the increase in money supply will be absorbed by money demand in a more timely and complete manner, thereby maintaining a stable and predictable value of the U.S. Dollar – a requisite frame of reference, since all economic activity is based on its value.

Real time, market based prices of commodities, foreign currencies and future investment opportunities (bond yields) provide better signals for altering the money supply. The market would set interest rates and determine the money supply, which would require much less monetary intervention by the Federal Reserve.

In fact, it is advantageous for wages to rise so long as they are met with commensurate gains in productivity.

This will ensure cost-effective unit production and strong purchasing power, where unit wage increases tend to be small, stable and roughly equivalent to unit commodity price increases over similar time frames.

Predicating credit creation on the production of real assets will help ensure strong productivity gains in the future, thereby creating an environment ripe for employment, economic growth, moderate and stable inflation, and strong and stable purchasing power.

Direct domestic investment has been weak over the past few decades as a result of this misguided monetary policy. This is the worst economic recovery precisely because this is the worst recovery in business investment.

A volatile dollar inhibits business investment. Business investment acts as the fuel for the train engine that drives economic growth. Consumption is the caboose that follows: it does not push the train. One only consumes what has already been produced.

Currently, Put Growth First is actively working with members of Congress, including the House Freedom Caucus led by Rep. Jim Jordan, R-Ohio, and will soon launch a Growth Task Force with input from caucus members such as Rep. David Schweikert, R – Arizona.

Put Growth First has also been involved in helping to advance House of Representatives bill 1176 in the previous 113th Congress, sponsored by Rep. Kevin Brady, R.-Texas, that would establish a Centennial Monetary Commission to examine United States monetary policy, evaluate alternative monetary regimes, and recommend a course of monetary policy going forward. It was reintroduced to the House of Representatives on June 25, 2015, as H.R. 2912: Centennial Monetary Commission Act of 2015.

Senator Cruz is right to promote a stable U.S. Dollar, which is backed by real assets that are produced with an efficient use of limited resources.

It will increase business investment, productivity, income and purchasing power over the long term for the masses.

It is important to couple this sound monetary policy with a pro-growth tax reform plan to ensure optimal results.  I will elaborate on my tax proposal in the following column.

© 2015 Newsmax Finance. All rights reserved.

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Why Economists Fail

Newsmax_Image_102315_WhyEconomistsFail

By Barry Elias | Friday, 23 Oct 2015 07:24 AM

I attended a presentation this past week at Cooper Union College in Manhattan by an economist promoting his new book.

I was rather aghast to hear him say: “No one” predicted the global economic crisis and experts did not foresee how slow the recovery would be.

Following the collapse of Bear Stearns on March 17, 2008, I divested most of my family’s investment portfolio from the market when the Dow Jones Industrial Average hovered near 12,000. By September of that year, the Dow reached its nadir – around 6,500.

At that time, I expected the unemployment rate to double from 5 percent to 10 percent, which it did. I also suggested the global recovery may take a decade or two to return to robust growth, since the crisis was the result of financial mismanagement that spanned several decades.

Further, on May 6, 2010, the day of the infamous “Flash Crash,” my article entitled “Why I Divested From the Dow” was published: About six hours later, the Dow had plummeted about 1,000 points.

The Cambridge-educated economist that I alluded to earlier is Adair Turner, the chairman of the Institute for New Economic Thinking; a member of the United Kingdom’s Financial Policy Committee: and the former chairman of the Financial Services Authority (FSA) until its abolition at the end of March 2013.

The FSA was an independent regulatory body for the financial services industry in the United Kingdom (U.K.) between 2001 and 2013. It was appointed by the Treasury and funded entirely by fees charged to financial firms.

Due to the apparent regulatory failure of banks during the financial crisis, the U.K. government abolished and replaced the “failed” FSA on April 1, 2013 with two new agencies: the Financial Conduct Authority (FCA) and the Prudential Regulation Authority of the Bank of England, in an effort to strengthen England’s financial system with a more forward-looking perspective.

While the FSA under Turner’s leadership presided over the near-total collapse of several major financial institutions, including the merger of Lloyds Bank with ailing HBOS in September 2008, Turner claimed in February 2009, as well as today, that other global regulatory authorities also failed to predict the economic collapse. He did not apologize for the actions of the FSA, and believes the intellectual failure was the result of a focus on processes and procedures, in lieu of the larger economic landscape.

Economists ought to take note of that admission and view the world with greater breadth and depth, especially before proposing public policy prescriptions that may have implications for many decades to come.

In his new book, Turner argues most credit formation is not necessary for economic development. He suggests excess credit drives real estate booms and wealth inequality, which then lead to financial crises and depression. Turner believes banks need to increase capital and reduce real estate lending, and debt needs to be taxed as a form of “economic pollution.” I wholeheartedly agree with the premise and prescriptions presented.

Income inequality is self-reinforcing, since wealthier households consume a smaller percentage of their income, and savings tend to be invested in short-term, speculative, and arbitraged financial assets. This dynamic undermines employment and economic growth for the masses as compared with direct investment. Favorable tax rates on investment income, especially for hedge fund managers, perpetuates this viscous cycle.

Since 1970, financial firms expanded credit among themselves and households seeking real estate, because it involved a simple and secure business model: real estate collateral valuations were more predictable as compared with the assessment of an entrepreneurial endeavor. This methodology permitted the excessive refinancing of existing assets, and less on the creation of new ones.

Financial firm credit skyrocketed from 10 percent of GDP in 1970 to 125 percent in 2008, while that for household credit rose from 40 percent to about 90 percent, which included toxic subprime mortgages. (During the same period, federal government debt as a share of GDP increased from 35 percent to 60 percent, and that for non-financial corporate debt rose slightly, from 35 percent to 40 percent.)

The financial firms essentially transferred wealth among themselves and others instead of creating new wealth. This led to less optimal employment and income growth for the masses, since direct investment in business endeavors was on the wane. Instead, financial products that were derived from preexisting assets exploded, and wealth and income inequality grew.

The net worth of the financial sector was negative from 1996 through 2007, reaching a nadir of negative $1.46 trillion in April 2007. Quantitative easing by the Federal Reserve following the financial crisis put the financial industry in positive territory, but it turned negative at the end of 2013, and by of June of 2015 it stood at negative $809 billion.

Why was the financial industry protected so well?

Some suggest a significant number of economists with keen academic and think-credentials regularly accept funding from corporations to provide “objective” analyses that actually promote corporate objectives and defy evidence and logic.

Let’s keep the economists honest and forward-looking, shall we?

© 2015 Newsmax Finance. All rights reserved.

Too Big to Jail Is Being Tested by US LIBOR Trial

Friday, 16 Oct 2015 07:27 AM

Dollar banknotes, handcuffs and judge's gavel isolated on white

Financial behemoths have paid handsome penalties to settle criminal and civil charges related to manipulation of the LIBOR. Now American citizens may be in jeopardy, thereby disrupting the implication that bank employees are “too big to jail.”

In recent years, more than $5 billion have been ponied up by several financial institutions for these transgressions: $2.5 billion from Deutsch Bank, $1.5 billion from UBS, $450 million from Barclays, and $325 million from Rabobank. Other perpetrators include Citigroup, The Royal Bank of Scotland, JP Morgan, Lloyds, and ICAP.

LIBOR, or the London Interbank Offered Rate, is the interest rate paid by banks to borrow funds from other banks. It represents the average lending rate offered by the 16 participating banks. These offers are submitted daily to the British Bankers’ Association for five currencies and 7 borrowing periods, spanning overnight to one year loans. Other lenders, including financial institutions, mortgage banks, and credit card companies set their rates relative to these. It is estimated that $350 trillion of derivatives and other financial products are based on the LIBOR.

The Justice Department issued a memo last month that prioritizes the investigation of employees for financial malfeasance before seeking settlement with corporations. In an important test for U.S. prosecutors, two Rabobank employees are now being tried in a Manhattan federal court for manipulating LIBOR in order to benefit other Rabobank traders’ trading positions that were tied to the LIBOR. The traders on trial are Anthony Conti, a senior U.S. dollar trader, and Anthony Allen, a former global head of liquidity and finance, and supervisor of Rabobank’s Libor submitters, including Mr. Conti. They are alleged to have conspired to rig the rate on or about May 2006 through early 2011.

Thirteen individuals have been charged thus far in the U.S. in relation to the LIBOR investigation. While several defendants have pleaded guilty, including three other former Rabobank traders, none have gone to trial yet. Six former brokers accused of rigging LIBOR are currently on trial in the U.K. This comes on the heels of Tom Hayes’ conviction in London several months ago. He was a former UBS and Citigroup trader sentenced to 14 years for LIBOR manipulation.

Former Federal Reserve Chairman Ben Bernanke believes some Wall Street executives deserve jail time for their roles in the financial crisis, since individuals, not abstract firms, committed these crimes. He lays the blame with the Department of Justice and others who are responsible for enforcing the laws of our country.

Wide swaths of the political spectrum are extremely dismayed with the way the financial industry operates. In the recent debate, democratic presidential candidate Bernie Sanders claimed the banking business model is one predicated on “fraud.” And republican presidential candidate Donald Trump believes too many in the financial industry do not pay their fair share of taxes.

The maximum tax rate for capital gains on financial products is 23.8 percent, while that for ordinary income is 39.6 percent. Further, unlike ordinary income, capital gains are not subjected to social security taxes of 12.4 percent, which is shared equally by the employee and employer.

The only effective deterrent to financial misdeeds is the possibility of personal punishment.

© 2015 Newsmax Finance. All rights reserved.

China Shows Worrying Signs of Slowdown as Investors Weigh Risks

The Global Recession of 2008 took decades to manifest. The recovery may take just as long.

More than four years ago, I suggested the Chinese economy was headed toward economic slowdown, which would have adverse consequences for the rest of the world. Today, that prognostication seems frighteningly real.

From 2001 to 2010, consumption as a share of GDP in China fell to 36 percent from 46 percent, while the near reverse occurred for investment, rising to 47 percent from 36 percent.

This high level of investment, which was financed with large quantities of debt, could not be supported by the current levels of income. In essence, the Chinese built homes, offices and manufacturing plants that they neither needed nor had the ability to support financially.

Since 2007, China embarked on a debt-driven plan to increase domestic investment, income and economic growth, expanding total debt from $7 trillion to $28 trillion.

As a share of GDP, its debt more than doubled from 130 percent in 2009 to 282 percent by mid-2014, making it larger than that of the United States or Germany.

Roughly half of the loans are associated directly or indirectly with China’s real estate market; unregulated shadow banking now accounts for approximately half of all new lending; and the debt of many local governments is likely unmanageable, according to a McKinsey & Co. study.

China maintains a large presence on the world’s economic stage. By 2011, it contributed 40 percent of the world’s economic growth. In 2014, China was the third-largest importer, closely behind the United States and the European Union, with $1.96 trillion of imports, and the largest exporter with $2.34 trillion in sales. Currently, it accounts for 16 percent of world economic activity, the equivalent of the U.S. in purchasing power parity terms.

China purchases about half the world’s aluminum, nickel and steel, and nearly a third of its cotton and rice, as well as iron ore, copper and coal, which created a boon in commodity prices.

It also expanded its foreign direct investment program, growing ten-fold from 2005 to 2013, and was the largest investor in five of the 10 riskiest countries.

Given China’s premier global economic standing, its difficulties are metastasizing worldwide. It has begun reducing capital investment, causing commodity prices to fall and hurting many of its trading partners, including South Korea, Japan, the U.S., Taiwan, Germany, Australia, and Brazil.

China now contributes 30 percent to world GDP growth, down from 40 percent four years ago.

Structural demographic trends portend poorly for China, since its working-age population is beginning to contract. Lower employment, income and economic growth may precipitate asset sales to service outstanding debt — leading to real estate price declines, lower loan collateral, and less lending.

Further complicating matters, in 2007, Li Keqiang, now China’s premier, told the U.S. ambassador that the Chinese GDP figures are “man-made” and therefore unreliable, according to a memo released by WikiLeaks.

Since then, macroeconomic research firms have attempted to measure these data more independently. The official Chinese estimate of economic growth stands at 7 percent. This is in stark contrast to that suggested by Capital Economics at 4.1 percent, Conference Board/Hitotsubashi at 3.8 percent and Lombard Street at 3.7 percent.

In a bit of monetary and financial schizophrenia, China has recently vacillated between a market and state-driven economy to manage its economic affairs.

In an attempt to have the renminbi included in the International Monetary Fund’s Special Drawing Rights, China sought a more flexible exchange rate, only to see it plunge in value. This led it to strengthen the currency with daily purchases totaling tens of billions of dollars.

Investors suspect the yuan will weaken an additional 4 percent to 6.75 percent relative to the dollar. This anticipated decline is in addition to the 4.4 percent drop since August 11.

Daily trading in yuan options skyrocketed to $12 billion following the currency intervention by the People’s Bank of China from an average of $4.2 billion. The cost to insure $100 million against a weaker yuan ballooned from $30,500 to $1.7 million during this time, suggesting further currency erosion.

In a reversal, after discouraging the use of borrowed funds to purchase stocks, the Chinese government sanctioned this activity by providing funds to state lenders. In addition, it limited IPOs to reduce competition with existing equities; permitted a pension fund to purchase stock; limited stock sales by large shareholders; forced company stock buyback programs; lowered interest rates and deposit reserve requirements; and spent more than $200 billion buying Chinese stocks since early July, with the likelihood that this rate of spending would need to be indefinite.

The Chinese concluded this stock-propping program was unsustainable and decided to discontinue its operation. The gains of 60 percent since December 2014 have evaporated completely.

In March 2007, nine months before the beginning of the Great Recession, the U.S. experienced a government security yield curve inversion, when short-term interest rates were higher than long term rates: the three-month Treasury bill at 5.1 percent and two-year Treasury note at 4.6 percent.

Typically, longer-term investments are more risky and warrant greater returns on investment. However, yield inversion signifies greater short-term risk associated with an anticipated economic downturn.

Since 1970, yield inversions predicted an economic contraction six of seven times. By March 2008, the yield inversion was reversed, and short-term rates were lower than long-term: 1.11 percent for the three-month Treasury bill and 1.33 percent for the two-year Treasury note.

In the case of China, the yield inversion has lasted more than four years. On August 25, the two-year Chinese government bond stood at 3.50 percent and the 10-year bond at 3.48 percent: a minor inversion still exists.

This long duration signals the economic slowdown may continue for many years and possibly approach zero growth with negative global implications.

© 2015 Newsmax Finance. All rights reserved.